Is It Too Late to Buy the Rally in Small Caps?

by Daniel Putnam | March 7, 2014 6:00 am

Domestic small-cap stocks have been annihilating all other asset classes since the beginning of the year, building on their gain of nearly 39% in 2013.

[1]The iShares Russell 2000 ETF (IWM[2]) has rallied nearly 4% year-to-date, better than large caps, international stocks, bonds, and just about every other significant market segment with the exception of gold.

The question now is whether this rally has gone too far, or whether small caps still have room to run.

Fortress America

The case for small-cap stocks is easy to make right now. Since the start of the year, the largest issues that have unnerved investors have originated from overseas: instability in emerging market currencies, worries about credit conditions in China, and more recently the conflict in Ukraine.

These headwinds have led to underperformance not just for U.S. large caps, which have a larger percentage of overseas revenurs than their small-cap stocks counterparts, but also the international markets. Europe has barely eked out a gain, while Japan and the emerging markets have both posted losses in the mid-single digits.

In the United States, meanwhile, it’s business as usual — and small caps continue to be the best play on the relative stability here at home. Small-cap stocks are the asset class that is most isolated from the trouble overseas, and also the best way to play the improving growth outlook for the United States. For investors looking to put incremental cash to work in stocks, the choice has been an easy one.

From a longer-term standpoint, another important tailwind for small-caps has been supply and demand. According to a T. Rowe Price (TROW[3]) report titled “Shrinking U.S. Equity Opportunity Set Poses Challenges for Small-Cap Investors,”[4] a tougher regulatory environment is preventing small companies from coming to the market via IPOs. As a result, the pipeline of new companies isn’t coming close to replacing those that have moved out of the small cap indices.

The reportstates: “The erosion of the small-cap opportunity set can be seen in the composition of the Wilshire 5000 Index, which declined from more than 7,000 stocks in 1999 to just 3,776 at the end of 2013.” With so much cash looking for a home in the era of low rates, this shrinking demand has been a boon for small caps, and it should continue to provide support in the coming years.

Together, these factors indicates that small caps can continue to outperform in the short term, barring an unforeseen drop-off in economic data in the weeks and months ahead. Or, put another way: ride the wave as long as you can.

Why Small Caps May Lose Their Gusto

For investors with a longer-term horizon, the outlook is a little dicier. Since the March 9, 2009 low, IWM has gained 275%, for an average annual return of 30.3%. One result is that valuations have rocketed to levels that are extremely high on a historical basis.

The Russell 2000 Index is trading at about 21 times forward earnings, well above the 10-year average of roughly 17. Small-cap stocks continue to offer attractive growth — with five-year estimates of 11.6% for the asset class as a whole — but at 21 times earnings, the price is steep.

Using this valuation level as a starting point, the opportunity for returns in the next five years is muted at best. Given small caps’ volatility, this indicates an unfavorable risk-reward profile for anyone committing new cash to the asset class today.

The other issue to consider is the general froth currently being exhibited within the small-cap space. According to ETF.com, the ProShares Ultra Russell 2000 ETF (UWM[5]) has pulled in more than $1.1 billion in assets year-to-date — ninth-highest among all ETFs in the United States.

That’s an unusually large amount of money for a leveraged (2x) ETF within such a short period of time, indicating that investors are tripping over themselves to take on risk here.

It’s also worth noting that the surge in biotechnology stocks has played a huge role in small caps’ outperformance, a trend that reflects an extension of investors’ search for domestic names with organic growth and high beta.

However, the sector is getting extremely bubbly here. Yesterday, Michael Ide of ValueWalk reported[6] that the pharma/biotech component of the Russell 2000 Index is up 24% year-to-date. As a result, the year-to-date return for the overall index (3.8% as of March 5) has surged well above the 0% median return for all stocks in the index.

As the table below shows, nine of the top ten year-to-date performers in the Russell Index are pharma/biotechs. If this sector loses its luster, small-cap stocks will quickly cough up their performance advantage.

Stock

Ticker

YTD Return

Intercept Pharmaceuticals

ICPT

340.7%

Digimarc

DMRC

89.9%

Neurocrine Biosciences

NBIX

83.0%

NewLink Genetics

NLNK

68.2%

Cell Therapeutics

CTIC

66.2%

Conatus Pharmaceuticals

CNAT

63.9%

TG Therapeutics

TGTX

53.9%

PTC Therapeutics

PTCT

53.6%

Karyopharm Therapeutics

KPTI

52.3%

Insys Therapeutics

INSY

52.0%

The Bottom Line

Small caps still have a lot going for them, and investors may be hesitant to sell in a market that has left anyone but the most ardent bulls behind. Still, with valuations where they are and such strong gains already in the books, it’s time to take a more cautious approach to this space.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.